NORWOOD FINANCIAL CORP - Quarter Report: 2008 June (Form 10-Q)

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

 

FORM 10-Q

(Mark One)

 

 

For the quarterly period ended June 30, 2008

OR

 

For the transition period from _________________ to ________________

 

Commission file number 0-28366

 

 

 

 

 

 

Indicate by check (x) whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.  Yes x No   o

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):

 

 

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act): o Yes               x No

 

Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date.

 

 

 

 

NORWOOD FINANCIAL CORP.

FORM 10-Q

FOR THE QUARTER ENDED JUNE 30, 2008

INDEX

 

 

 

 

 

 

 

 

 

PART I. FINANCIAL INFORMATION

Item 1. Financial Statements

 

NORWOOD FINANCIAL CORP.

Consolidated Balance Sheets (unaudited)

(dollars in thousands, except per share data)

 

 

 

See accompanying notes to the unaudited consolidated financial statements

 

 

NORWOOD FINANCIAL CORP.

Consolidated Statements of Income (unaudited)

(dollars in thousands, except per share data)

 

 

See accompanying notes to the unaudited consolidated financial statements

 

NORWOOD FINANCIAL CORP.

Consolidated Statements of Changes in Stockholders’ Equity (unaudited)\

 

 

 

See accompanying notes to the consolidated financial statements

 

 

NORWOOD FINANCIAL CORP.

Consolidated Statements of Cash Flows (unaudited)

(dollars in thousands)

 

 

See accompanying notes to the unaudited consolidated financial statements

 

Notes to Unaudited Consolidated Financial Statements

1. Basis of Presentation

 

The unaudited consolidated financial statements include the accounts of Norwood Financial Corp. (Company) and its wholly-owned subsidiary, Wayne Bank (Bank) and the Bank’s wholly-owned subsidiaries, WCB Realty Corp., Norwood Investment Corp. and WTRO Properties. All significant intercompany transactions have been eliminated in consolidation.

 

The accompanying unaudited consolidated financial statements have been prepared in conformity with generally accepted accounting principles for interim financial statements and with instructions to Form 10-Q. Accordingly, they do not include all of the information and footnotes required by generally accepted principles for complete financial statements. In preparing the financial statements, management is required to make estimates and assumptions that affect the reported amounts of assets and liabilities as of the date of the balance sheet and revenues and expenses for the period. Actual results could differ from those estimates. The financial statements reflect, in the opinion of management all normal, recurring adjustments necessary to present fairly the financial position of the Company. The operating results for the three and six month periods ended June 30, 2008 are not necessarily indicative of the results that may be expected for the year ending December 31, 2008 or any other future interim period.

 

These statements should be read in conjunction with the consolidated financial statements and related notes which are incorporated by reference in the Company’s Annual Report on Form 10-K for the year-ended December 31, 2007.

 

2. Earnings Per Share

 

Basic earnings per share represents income available to common stockholders divided by the weighted average number of common shares outstanding during the period. Diluted earnings per share reflects additional common shares that would have been outstanding if dilutive potential common shares had been issued, as well as any adjustment to income that would result from the assumed issuance. Potential common shares that may be issued by the Company relate solely to outstanding stock options and are determined using the treasury stock method.

 

The following table sets forth the weighted average number of common shares used in the computations of basic and diluted earnings per share:

 

 

Stock options which had no intrinsic value because their effect would be anti-dilutive and therefore would not be included in the diluted EPS calculation were 44,000 and 22,500 as of June 30, 2008 and 2007, respectively.

 

 

3. Stock-Based Compensation

 

The Company’s stockholders approved the Norwood Financial Corp 2006 Stock Option Plan at the annual meeting on April 25, 2006 and the Company awarded 47,700 options in 2006, and 22,000 options in 2007, all of which have a twelve month vesting period. As of June 30, 2008, there was approximately $77,000 of total unrecognized compensation cost related to nonvested options under the plan, which will be fully amortized by December 31, 2008.

 

No stock options were granted for the six months ended June 30, 2008. A summary of stock options from all plans, adjusted for stock dividends declared, is shown below.

 

 

Intrinsic value represents the amount by which the market price of the stock on the measurement date exceeded the exercise price of the option. The intrinsic value of options exercised during the six months ended June 30, 2008 was $265,000, cash received from such exercises was $254,000 and the tax benefit recognized was $83,000.

 

4. Cash Flow Information

 

For the purposes of reporting cash flows, cash and cash equivalents include cash on hand, amounts due from banks, interest-bearing deposits with banks and federal funds sold, all of which mature within 90 days.

 

Cash payments for interest for the six months ended June 30, 2008 and 2007 were $5,716,000 and $6,040,000 respectively. Cash payments for income taxes in 2008 were $1,583,000 compared to $1,333,000 in 2007. Non-cash investing activities for 2008 and 2007 included foreclosed mortgage loans and repossession of other assets of $1,223,000 and $35,000, respectively.

 

5. Comprehensive Income

 

Accounting principles generally accepted in the United States of America require that recognized revenue, expenses, gains and losses be included in net income. Although certain changes in assets and liabilities such as unrealized gains and losses on available for sale securities, are reported as a separate component of the equity section of the balance sheet, such items, along with net income, are components of comprehensive income. The components of other comprehensive income and related tax effects are as follows.

 

 

 

 

 

 

The Bank is a party to financial instruments with off-balance-sheet risk in the normal course of business to meet the financing needs of its customers. These financial instruments include commitments to extend credit and letters of credit. Those instruments involve, to varying degrees, elements of credit and interest rate risk in excess of the amount recognized in the balance sheets.

 

The Bank’s exposure to credit loss in the event of nonperformance by the other party to the financial instrument for commitments to extend credit and letters of credit is represented by the contractual amount of those instruments. The Bank uses the same credit policies in making commitments and conditional obligations as it does for on-balance sheet instruments.

 

A summary of the Bank’s financial instrument commitments is as follows:

(in thousands)

 

 

Commitments to extend credit are agreements to lend to a customer as long as there is no violation of any condition established in the contract. Commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee. Since some of the commitments are expected to expire without being drawn upon, the total commitment amount does not necessarily represent future cash requirements. The Bank evaluates each customer’s credit worthiness on a case-by-case basis. The amount of collateral obtained, if deemed necessary by the Bank upon extension of credit, is based on management’s credit evaluation of the customer and generally consists of real estate.

 

 

The Bank does not issue any guarantees that would require liability recognition or disclosure, other than its standby letters of credit. Standby letters of credit written are conditional commitments issued by the Bank to guarantee the performance of a customer to a third party. Generally, all letters of credit, when issued have expiration dates within one year. The credit risks involved in issuing letters of credit are essentially the same as those that are involved in extending loan facilities to customers. The Bank, generally, holds collateral and/or personal guarantees supporting these commitments. Management believes that the proceeds obtained through a liquidation of collateral and the enforcement of guarantees would be sufficient to cover the potential amount of future payment required under the corresponding guarantees. The current amount of the liability as of June 30, 2008 for guarantees under standby letters of credit issued is not material.

 

7. Fair Value Measurements

 

In September 2006, the FASB issued FASB Statement No. 157, Fair Value Measurements (“SFAS 157”), which defines fair value, establishes a framework for measuring fair value under GAAP, and expands disclosures about fair value measurements. SFAS 157 applies to other accounting pronouncements that require or permit fair value measurements. The standard is effective for financial statements issued for fiscal years beginning after November 15, 2007, and for interim periods within those fiscal years. The Company adopted SFAS 157 effective for its fiscal year beginning January 1, 2008. In December 2007, the FASB issued FASB Staff Position (FSP) No. SFAS 157-2, “Effective Date of FAS 157” for all non-financial assets and liabilities, except those that are recognized or disclosed at fair value on a recurring basis (at least annually) to fiscal years beginning after November 15, 2008 and interim periods within those fiscal years. The adoption of SFAS 157 and FSP No. FAS 157-2 had no impact on the amounts reported in the consolidated financial statements.

 

The primary effect of SFAS 157 on the Company was to expand the required disclosures pertaining to the methods used to determine fair values.

 

SFAS 157 establishes a fair value hierarchy that prioritizes the inputs to valuation methods used to measure fair value. The hierarchy gives the highest priority to unadjusted quoted prices in active markets for identical assets or liabilities (Level 1 measurements) and the lowest priority to unobservable inputs (Level 3 measurements). The three levels of the fair value hierarchy under SFAS 157 are as follows:

 

Level 1: Unadjusted quoted prices in active markets that are accessible at the measurement date for identical, unrestricted assets or liabilities.

 

Level 2: Quoted prices in markets that are not active, or inputs that are observable either directly or indirectly, for substantially the full term of the asset or liability.

 

Level 3: Prices or valuation techniques that require inputs that are both significant to the fair value measurement and are unobservable (i.e. supported with little or no market activity).

 

 

An asset or liability’s level within the fair value hierarchy is based on the lowest level of input that is significant to the fair value measurement.

 

For financial assets measured at fair value on a recurring basis, the fair value measurements by level within the fair value hierarchy used at June 30, 2008 are as follows:

 

 

The following valuation techniques were used to measure fair value of assets in the table above on a recurring basis as of June 30, 2008:

 

Available for Sale Securities:

The Company holds equity securities which are traded with quoted prices, on an active market. Such securities are carried at a market price quote and considered Level 1 Fair Values.

 

The Company also holds debt offerings of U.S. Government Agencies, state and political subdivisions, high-grade corporate obligations and mortgage-backed securities issued by U.S. Government agencies. The Company utilizes a third party source to provide fair value of its fixed income securities. The methodology consists of pricing models based on asset class and include available trade, bid, other market information, broker quotes, proprietary models, various databases and trading desk quotes. This valuation is based on observable inputs and is considered Level 2.

 

Imparied Loasn:

Impaired loans are evaluated and valued at the time the loan is first considered impaired. The realizable value is measured based on the value of the collateral securing the loan and is considered a Level 3 measurement. The value of real estate related collateral is established by a formal appraisal performed for the Company. The loan is carried at the lower of cost or market, net of any valuation allowance. Impaired loans are evaluated on a quarterly basis for additional impairment and adjusted as needed.

 

Other Real Estate Owned:

The realizable value is measured based on the value of the real estate less cost to sell and is considered a Level 3 measurement. The value of the real estate is established by formal appraisal performed by the Company.

 

 

The following is a reconciliation of the beginning and ending balances of recurring value measurements of impaired loans and other real estate owned using significant unobservable (Level 3) inputs:

 

 

8. New and Recently Adopted Accounting Pronouncements

 

In September 2006, the FASB’s Emerging Issues Task Force (EITF) issued EITF Issue No. 06-4, “Accounting for Deferred Compensation and Postretirement Benefit Aspects of Endorsement Split Dollar Life Insurance Arrangements: (EITF 06-4). EITF 06-4 requires the recognition of a liability related to the postretirement benefits covered by an endorsement split-dollar life insurance arrangement. The consensus highlights that the employer (who is also the policyholder) has a liability for the benefit it is providing to its employee. As such, if the policyholder has agreed to maintain the insurance policy in force for the employee’s benefit during his or her retirement, then the liability recognized during the employee’s active service period should be based on the future cost of insurance to be incurred during the employee’s retirement. Alternatively, if the policyholder has agreed to provide the employee with a death benefit, then the liability for the future death benefit should be recognized by following the guidance in SFAS No. 106 or Accounting Principles Board (APB) Opinion No. 12, as appropriate. For transition, an entity can choose to apply the guidance using either the following approaches: (a) a change in accounting principle through retrospective application to all periods presented or (b) a change in accounting principle through a cumulative-effect adjustment to the balance in retained earnings at the beginning of the year of adoption. The EITF is effective for fiscal years beginning after December 15, 2007, with early adoption permitted. The Company has chosen approach (b) and recorded a cumulative effect adjustment as of January 1, 2008 to the balance of retained earnings of $520,000, with $90,000 of Net Periodic Postretirement Benefit expense expected for the year ended December 31, 2008.

 

In February 2007, the FASB issued SFAS No. 159, “The Fair Value Option for Financial Assets and Financial Liabilities-including an amendment of FASB Statement No. 115”. SFAS No. 159 permits entities to choose to measure many financial instruments and certain other items at fair value. Unrealized gains and losses on items for which the fair value option has been elected will be recognized in earnings at each subsequent reporting date. SFAS No. 159 is effective for our Company January 1, 2008. The adoption of SFAS No. 159 did not have a material impact on our consolidated financial statements.

 

FASB Statement No. 141 (R) “Business Combinations” was issued in December of 2007. This Statement establishes principles and requirements for how the acquirer of a business recognizes and measures in its financial statements the identifiable assets acquired, the liabilities assumed, and any noncontrolling interest in the acquiree. The Statement also provides guidance for recognizing and measuring the goodwill acquired in the business combination and determines what information to disclose to enable users of the financial statements to evaluate the nature and financial effects of the business combination. The guidance will become effective as of the beginning of a company’s fiscal year beginning after December 15, 2008. This new pronouncement will impact the Company’s accounting for business combinations beginning January 1, 2009.

 

 

 

FASB Statement No. 160 “Noncontrolling Interests in Consolidated Financial Statements – an amendment of ARB No. 51” was issued in December of 2007. This Statement establishes accounting and reporting standards for the noncontrolling interest in a subsidiary and for the deconsolidation of a subsidiary. The guidance will become effective as of the beginning of a company’s fiscal year beginning after December 15, 2008. The Company believes that this new pronouncement will have an immaterial impact on the Company’s consolidated financial statements in future periods.

 

Staff Accounting Bulletin No. 109 (SAB 109), “Written Loan Commitments Recorded at Fair Value Through Earnings” expresses the views of the staff regarding written loan commitments that are accounted for at fair value through earnings under generally accepted accounting principles. To make the staff’s views consistent with current authoritative accounting guidance, the SAB revises and rescinds portions of SAB No. 105, “Application of Accounting Principles to Loan Commitments.” Specifically, the SAB revises the SEC staff’s views on incorporating expected net future cash flows related to loan servicing activities in the fair value measurement of a written loan commitment. The SAB retains the staff’s views on incorporating expected net future cash flows related to internally-developed intangible assets in the fair value measurement of a written loan commitment. The staff expects registrants to apply the views in Question 1 of SAB 109 on a prospective basis to derivative loan commitments issued or modified in fiscal quarters beginning after December 15, 2007. SAB 109 did not have a material impact on the Company’s consolidated financial statements.

 

 

 

In May 2008, the FASB issued FASB Staff Position (FSP) APB 14-1, “Accounting for Convertible Debt Instruments That May Be Settled in Cash upon Conversion (Including Partial Cash Settlement)” which clarifies the accounting for convertible debt instruments that may be settled in cash (including partial cash settlement) upon conversion. The FSP requires issuers to account separately for the liability and equity components of certain convertible debt instruments in a manner that reflects the issuer’s nonconvertible debt borrowing rate when interest cost is recognized. The FSP requires bifurcation of a component of the debt, classification of that component in equity and the accretion of the resulting discount on the debt to be recognized as part of interest expense. The FSP requires retrospective application to the terms of instruments as they existed for all periods presented. The FSP is effective for fiscal years beginning after December 15, 2008, and interim periods within those years. Early adoption is not permitted. The Company is currently evaluating the potential impact the new pronouncement will have on its consolidated financial statements.

 

In June 2008, the FASB issued FASB Staff Position (FSP) EITF 03-6-1, “Determining Whether Instruments Granted in Share-Based Payment Transactions Are Participating Securities.” This FSP clarifies that all outstanding unvested share-based payment awards that contain rights to nonforfeitable dividends participate in undistributed earnings with common shareholders. Awards of this nature are considered participating securities and the two-class method of computing basic and diluted earnings per share must be applied. This FSP is effective for fiscal years beginning after December 15, 2008. The Company is currently evaluating the potential impact the new pronouncement will have on its consolidated financial statements.

In June 2008, the FASB ratified EITF Issue No. 07-5, “Determining Whether an Instrument (or an Embedded Feature) Is Indexed to an Entity’s Own Stock” (EITF 07-5). EITF 07-5 provides that an entity should use a two step approach to evaluate whether an equity-linked financial instrument (or embedded feature) is indexed to its own stock, including evaluating the instrument’s contingent exercise and settlement provisions. It also clarifies the impact of foreign currency denominated strike prices and market-based employee stock option valuation instruments on the evaluation. EITF 07-5 is effective for fiscal years beginning after December 15, 2008. The Company is currently evaluating the potential impact the new pronouncement will have on its consolidated financial statements.

In June 2008, the FASB ratified EITF Issue No. 08-3, “Accounting for Lessees for Maintenance Deposits Under Lease Arrangements” (EITF 08-3). EITF 08-3 provides guidance for accounting for nonrefundable maintenance deposits. It also provides revenue recognition accounting guidance for the lessor. EITF 08-3 is effective for fiscal years beginning after December 15, 2008. The Company is currently evaluating the potential impact the new pronouncement will have on its consolidated financial statements.

Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations

 

Forward-Looking Statements

 

The Private Securities Litigation Reform Act of 1995 contains safe harbor provisions regarding forward-looking statements. When used in this discussion, the words believes, anticipates, contemplates, expects, and similar expressions are intended to identify forward-looking statements. Such statements are subject to certain risks and uncertainties, which could cause actual results to differ materially from those projected. Those risks and uncertainties include changes in interest rates, risks associated with the effect of opening a new branch, the ability to control costs and expenses, demand for real estate and general economic conditions. The Company undertakes no obligation to publicly release the results of any revisions to those forward-looking statements which may be made to reflect events or circumstances after the date hereof or to reflect the occurrence of unanticipated events.

 

 

Critical Accounting Policies

 

Note 2 to the Company’s consolidated financial statements for the year ended December 31, 2007 (incorporated by reference in Item 8 of the Form 10-K) lists significant accounting policies used in the development and presentation of its consolidated financial statements. This discussion and analysis, the significant accounting policies, and other financial statement disclosures identify and address key variables and other qualitative and quantitative factors that are necessary for an understanding and evaluation of the Company and its results of operations.

 

Material estimates that are particularly susceptible to significant change in the near term relate to the determination of the allowance for loan losses, accounting for stock options, the valuation of deferred tax assets and the determination of other-than-temporary impairment losses on securities. Please refer to the discussion of the allowance for loan losses calculation under “Non-performing Assets and Allowance for Loan Losses” in the “Financial Condition” section.

 

The deferred income taxes reflect temporary differences in the recognition of the revenue and expenses for tax reporting and financial statement purposes, principally because certain items are recognized in different periods for financial reporting and tax return purposes. Although realization is not assured, the Company believes that it is more likely than not that all deferred tax assets will be realized.

 

In estimating other-than-temporary impairment losses on securities, the Company considers 1) the length of time and extent to which the fair value has been less than cost 2) the financial condition of the issuer and 3) the intent and ability of the Company to hold the security to allow for a recovery to fair value. The Company believes that the unrealized losses at June 30, 2008 and December 31, 2007 represent temporary impairment of the securities, related to changes in interest rates.

 

Changes in Financial Condition

 

General

 

Total assets as of June 30, 2008 were $491.9 million compared to $480.6 million as of December 31, 2007, an increase of $11.3 million. The increase reflects a $6.8 million increase in securities available for sale and a $1.5 million increase in loans receivable, funded by a $15.4 million increase in short-term borrowings.

 

 

Securities

 

The fair value of securities available for sale as of June 30, 2008 was $130.8 million compared to $124.0 million as of December 31, 2007. The Company purchased $34.4 million of securities using the proceeds from $26.2 million of securities called, maturities and principal reductions and from short-term borrowings.

 

The carrying value of the Company’s securities portfolio (Available-For-Sale and Held-to-Maturity) consisted of the following:

 

 

The Company has securities in an unrealized loss position. In Management’s opinion, the unrealized losses reflect changes in interest rates subsequent to the acquisition of specific securities. The Company’s available-for-sale portfolio has an average repricing term of 3.6 years. Interest rates in the 2-5 year section of the treasury yield curve decreased during the six months ended June 30, 2008 favorably impacting the fair value of individual securities. This has been somewhat offset by a widening of credit spreads in the market. Management believes that the unrealized losses represent temporary impairment of the securities and are the result of changes in interest rates. The Company has the intent and ability to hold these investments until maturity or market price recovery and spreads. The Company monitors the credit ratings of its securities which may impact the valuation of the securities. Credit ratings were within Company policy guidelines at June 30, 2008 and December 31, 2007.

 

Loans Receivable

 

Loans receivable totaled $332.8 million compared to $331.3 million as of December 31, 2007. Residential real estate loans decreased $5.7 million due to the sale of $14.4 million of 30 year fixed rate residential mortgages. The loans were sold for interest rate risk management to shorten the average life of the mortgage loan portfolio. Commercial real estate loans increased $12.8 million during the period, reflecting new activity and the completion of $3.6 million of construction projects. The activity was principally centered in the Monroe County, Pennsylvania market area.

 

 

Set forth below is selected data relating to the composition of the loan portfolio at the dates indicated:

 

 

Allowance for Loan Losses and Non-performing Assets

 

Following is a summary of changes in the allowance for loan losses for the periods indicated:

 

 

The allowance for loan losses totaled $4,237,000 as of June 30, 2008 and represented 1.27% of total loans compared to $4,081,000 at year end, and $3,900,000 as of June 30, 2007. The Company had net charge-offs for the six months of $29,000 compared to $33,000 in the comparable period in 2007. The Company’s loan review process assesses the adequacy of the allowance for loan losses on a quarterly basis. The process includes an analysis of the risks inherent in the loan portfolio. It includes an analysis of impaired loans and a historical review of credit losses by loan type. Other factors considered include: concentration of credit in specific industries; economic and industry conditions; trends in delinquencies and loan classifications, large dollar exposures and loan growth. Management considers the allowance adequate at June 30, 2008 based on the Company’s criteria. However, there can be no assurance that the allowance for loan losses will be adequate to cover significant losses, if any; that might be incurred in the future.

 

As of June 30, 2008, non-performing loans totaled $308,000, which is .09% of total loans compared to $163,000, or 0.05% of total loans at December 31, 2007. The company had $1,977,000 in restructured loans as of June 30, 2008 related to land development loan to a borrower. The interest rate on the loan was reduced to improve the borrower’s cash flow. The recorded investment for impaired loans requiring a specific allowance for loan losses was $1,977,000 of which $192,000 was specifically reserved due to a shortfall in the collateral. The Company acquired a property with a Deed in Lieu of Foreclosure carried at $1,200,000. The property consists of undeveloped residential building lots in Monroe County, PA. The Company has retained an engineering firm to determine the steps necessary to complete the municipal approval process for development.

 

The following table sets forth information regarding non-performing loans, restructured loans and foreclosed real estate at the dates indicated:

 

 

Deposits  

 

Total deposits as of June 30, 2008 were $365.3 million decreasing from $370.0 million as of December 31, 2007.

 

Time deposits greater than $100,000 decreased $25.3 million due to the scheduled maturities of school districts and various large commercial deposits. A portion remained on deposit in money market and interest-bearing demand accounts. The Company expects to bid on school district time deposits in the third and fourth quarter of 2008.

 

 

The following table sets forth deposit balances as of the dates indicated.

 

 

Borrowings

 

Short-term borrowings as of June 30, 2008 totaled $42.1 million compared to $26.7 million as of December 31, 2007. The increase in short-term borrowings were principally used to offset the decrease in time deposits greater than $100,000 as well as fund investment purchases.

 

Short-term borrowings consist of the following:

(dollars in thousands)

 

 

Long-term debt consisted of the following:

 

 

The convertible notes contain an option that allows the FHLB, at quarterly intervals to change the note to an adjustable-rate advance at three-month LIBOR plus 11 to 17 basis points. If the notes are converted, the option allows the Bank to put the funds back to the FHLB at no charge.

 

Off- Balance Sheet Arrangements

 

The Bank is a party to financial instruments with off-balance sheet risk in the normal course of business to meet the financing needs of its customers. These financial instruments include commitments to extend credit and letters of credit. Those instruments involve, to varying degrees, elements of credit and interest rate risk in excess of the amount recognized in the balance sheet.

 

The Bank’s exposure to credit loss in the event of nonperformance by the other party to the financial instrument for commitments to extend credit and letters of credit is represented by the contractual amount of those instruments. The Bank uses the same credit policies in making commitments and conditional obligations as it does for on-balance sheet instruments.

 

A summary of the contractual amount of the Company’s financial instrument commitments is as follows:

 

 

Stockholders’ Equity and Capital Ratios

 

At June 30, 2008, total stockholders’ equity totaled $55.9 million, compared to $55.8 million as of December 31, 2007. The net change in stockholders’ equity was primarily due to $3,500,000 in net income, that was partially offset by $1,368,000 of cash dividends declared. In addition, accumulated other comprehensive income declined due to a decrease in fair value of securities in the available for sale portfolio, net of tax. This decrease in fair value is the result of a change in interest rates, which may impact the value of the securities. Because of interest rate volatility, the Company’s accumulated other comprehensive income could materially fluctuate for each interim and year-end period.      

 

A comparison of the Company’s regulatory capital ratios is as follows:

 

 

The minimum capital requirements imposed by the FDIC on the Bank for leverage, Tier 1 and Total Capital are 4%, 4% and 8%, respectively. The Company has similar capital requirements imposed by the Board of Governors of the Federal Reserve System (FRB). The Bank is also subject to more stringent Pennsylvania Department of Banking (PDB) guidelines. The Bank’s capital ratios do not differ significantly from the Company’s ratios. Although not

 

 

adopted in regulation form, the PDB utilizes capital standards requiring a minimum of 6.5% leverage capital and 10% total capital. The Company and the Bank were in compliance with the FRB, FDIC and PDB capital requirements as of June 30, 2008 and December 31, 2007.

 

Liquidity

 

As of June 30, 2008, the Company had cash and cash equivalents of $9.7 million in the form of cash, due from banks, federal funds and short-term deposits with other institutions. In addition, the Company had total securities available for sale of $130.8 million which could be used for liquidity needs. This totals $140.5 million and represents 28.6% of total assets compared to $133.1 million and 27.7% of total assets as of December 31, 2007. The Company also monitors other liquidity measures, all of which were within the Company’s policy guidelines as of June 30, 2008 and December 31, 2007. Based upon these measures, the Company believes its liquidity is adequate.

 

Capital Resources

 

The Company has a line of credit commitment available from the Federal Home Loan Bank (FHLB) of Pittsburgh for borrowings of up to $20,000,000 which expires in December 2011. There were $13,000,000 borrowings under this line at June 30, 2008 and $-0- at December 31, 2007.

 

The Company has a line of credit commitment from Atlantic Central Bankers Bank for $7,000,000, which expires in May 2009 and Wachovia Bank for $2,000,000 which has no stated expiration date. There were no borrowings under these lines as of June 30, 2008 and December 31, 2007. The Company has a line of credit commitment available which has no stated expiration date from PNC for $12,000,000. Borrowings under this line were $10,551,000 as of June 30, 2008 and $800,000 as of December 31, 2007.

 

The Bank’s maximum borrowing capacity with the Federal Home Loan Bank was approximately $221,000,000 of which $36,000,000 was outstanding at June 30, 2008 and $23,000,000 was outstanding at December 31, 2007. Advances from the Federal Home Loan Bank are secured by qualifying assets of the Bank.   

 

Non-GAAP Financial Measures

 

This report contains or references fully taxable-equivalent (fte) interest income and net interest income, which are non-GAAP financial measures. Interest income (fte) and net interest income (fte) are derived from GAAP interest income and net interest income using an assumed tax rate of 34%. We believe the presentation of interest income (fte) and net interest income (fte) ensures comparability of interest income and net interest income arising from both taxable and tax-exempt sources and is consistent with industry practice. Net interest income (fte) is reconciled to GAAP net interest income on pages 22 and 26. Although the Company believes that these non-GAAP financial measures enhance investors’ understanding of our business and performance, these non-GAAP financial measures should not be considered an alternative to GAAP measures.

 

 

 

Results of Operations

NORWOOD FINANCIAL CORP.

Consolidated Average Balance Sheets with Resultant Interest and Rates

 

 

 

 

Rate/Volume Analysis. The following table shows the fully taxable equivalent effect of changes in volumes and rates on interest income and interest expense. Changes in net interest income that could not be specifically identified as either a rate or volume change were allocated proportionately to changes in volume and changes in rate.

 

 

 

 

 

 

Comparison of Operating Results for Three Months Ended June 30, 2008 and June 30, 2007

 

General

 

For the three months ended June 30, 2008, net income totaled $1,721,000, an increase of $151,000, or 9.6% over the $1,570,000 earned in the similar period of 2007. Earnings per share for the current period were $.63 basic and $.62 on a diluted basis compared to $.56 basic and $.55 on a diluted basis for the three months ended June 30, 2007. The resulting annualized return on average assets and return on average equity for the three months ended June 30, 2008 were 1.42% and 12.19%, respectively, compared to 1.35% and 11.77% respectively, for the similar period in 2007.

 

The following table sets forth changes in net income:

 

 

Net Interest Income

 

Net interest income on a fully taxable equivalent basis (fte) for the three months ended June 30, 2008 totaled $4,737,000, an increase of $287,000 or 6.5%, over the similar period in 2007. The fte net interest spread and net interest margin were 3.50% and 4.06%, respectively for the three months ended June 30, 2008 compared to 3.31% and 4.00% respectively, for the similar period in 2007.

 

Interest income (fte) totaled $7,116,000 with a yield on average earning assets of 6.10% compared to $7,410,000 and 6.67% for the 2007 period. The decrease in yield was principally due to lower prime interest rate which was 5.00% as of June 30, 2008 compared to 8.25% as of June 30, 2007. The Company has $65 million of floating rate loans tied to prime. As a result, the fte yield on loans declined to 6.59% for the current period from 7.40% for the similar period in 2007. The yield on the securities available for sale portfolio increased to 4.92% for the three months ended June 30, 2008 from 4.74% for the three months ended June 30, 2007. The increase in yield was the result of lower yielding securities, originally purchased in the lower interest rate

 

 

environment of 2003 and 2004, maturing with the proceeds invested in securities with higher yields. Also, an increase of $21.9 million in average earning assets partially offset the lower yield on loans.

 

Interest expense for the three months ended June 30, 2008 totaled $2,379,000 at an average cost of 2.60% compared to $2,960,000 at an average cost of 3.36% for the similar period in 2007. With the decline in short-term interest rates, the Company reduced rates paid on its money market accounts and cash management product, which is included in short-term borrowings. The cost of time deposits decreased to 3.82% in the current period from 4.57% for the similar period in 2007. As time deposits matured in 2008, they repriced at the current lower rates resulting in the decrease.

 

Other Income

 

Other income totaled $962,000 for the three months ended June 30, 2008 an increase of $105,000 from $857,000 in the similar period in 2007. Service charges and fees increased $35,000 principally due to a higher volume of non-sufficient fees. Revenues from the sale of title insurance included in other, increased $18,000. Commissions on annuities and mutual funds increased $29,000 on a higher volume of fixed annuity sales.

 

Other Expense

 

Other expense totaled $2,972,000 for the three months ended June 30, 2008, an increase of $125,000 or 4.4% over $2,847,000 for the similar period in 2007. Salaries and employee benefits costs increased $60,000, or 4.2%. Expenses related to a property acquired with a Deed in Lieu of Foreclosure totaled $52,000 which included delinquent real estate taxes and engineering costs included in Other.

 

Income Tax Expense

 

Income tax expense totaled $733,000 for an effective tax rate of 29.9% for the current period compared to $671,000 and an effective tax rate of 29.9% for the similar period in 2007.

 

 

Results of Operations

NORWOOD FINANCIAL CORP.

Consolidated Average Balance Sheets with Resultant Interest and Rates

 

 

 

 

Rate/Volume Analysis

 

The following table shows the fully taxable equivalent effect of changes in volumes and rates on interest income and interest expense. Changes in net interest income that could not be specifically identified as either a rate or volume change were allocated proportionately to changes in volume and changes in rate.

 

 

 

Comparison of Operating Results for Six Months Ended June 30, 2008 and June 30, 2007

 

General

 

Net income for the six months ended June 30, 2008 totaled $3,500,000, increasing $467,000, or 15.4% over the $3,033,000 earned in the similar period in 2007. Basic and diluted earnings per share were $1.28 and $1.26, respectively, in the 2008 period compared to $1.09 and $1.07, respectively, for the similar period in 2007. The resulting annualized return on average assets for the six months ended June 30, 2008 was 1.45%, with an annualized return on average equity of 12.44% as compared to 1.32% and 11.52% for the 2007 period.

 

 

 

The following table sets forth changes in net income:

 

 

Net Interest Income

 

Net interest income on a fully taxable equivalent basis (fte) for the six months ended June 30, 2008 totaled $9,217,000, an increase of $547,000, or 6.3% over the similar period in 2007. The fte net interest spread and net interest margin were 3.37% and 3.98% respectively, for the six months ended June 30, 2008 compared to 3.23% and 3.93%, respectively, for the similar period in 2007.

 

Interest income (fte) totaled $14,421,000 with a yield on average earning assets of 6.23% compared to $14,618,000 with a yield of 6.63% for the 2007 period. The decrease in yield was principally due to the lower prime interest rate which was 5.00% as of June 30, 2008 decreasing from 8.25% as of June 30, 2007. The Company has $65 million of floating rate loans tied to the prime rate. As a result, the fte yield on loans fell to 6.76% in the current period from 7.37% in the 2007 period. The yield on securities available for sale increased to 4.94% from 4.60% as lower yielding securities matured with the proceeds invested at higher rates. An increase of $21.5 million of average earning assets also helped to partially offset the lower yield on loans.

 

Interest expense for the six months ended June 30, 2008 totaled $5,204,000 at an average cost of 2.86% compared to $5,948,000 and 3.38% for the similar period in 2007. As a result of the decrease in short-term interest rates which began in the third quarter of 2007, the Company reduced rates paid on its money market deposit accounts and cash management products which are included in short-term borrowings. Also, the cost of time deposits declined to 4.08% in the current period from 4.57% for the similar period in 2007. As time deposits matured, they repriced at the current lower rates resulting in the decrease.

 

 

Other Income

 

Other income totaled $2,224,000 for the six months ended June 30, 2008 compared to $1,751,000 for the similar period in 2007, an increase of $473,000. The increase was principally due to the gain of $396,000 on the sale of $14.4 million of 30 year fixed rate residential mortgages to FNMA compared to $8,000 of similar gains in 2007. The loans were sold for interest rate risk management purposes. Service charges and fees increased $67,000 due to $49,000 increase in non-sufficient fund and overdraft fees, due to higher volume of title insurance revenues, $17,000 and mortgage servicing income, $13,000.

 

Other Expense

 

Other expense totaled $5,933,000 for the six months ended June 30, 2008, an increase of $225,000 or 3.9% over $5,708,000 in the similar period of 2007. Salaries and employee benefit costs increased $109,000, or 3.7%. Data processing related expenses increased $26,000 or 7.6% principally due to costs associated with the Bank’s remote deposit capture product and branch image capture. The current period includes $52,000 of expense related to a property acquired by Deed in Lieu of Foreclosure with no such costs in 2007 period. The efficiency ratio, other expense as a percentage of net interest income (fte) plus other income, was 51.9% for the six months ended June 30, 2008 compared to 54.8% for the similar period in 2007.

 

Income Tax Expense

 

Income tax expense totaled $1,504,000 for an effective tax rate of 30.1% for the period ending June 30, 2008 compared to $1,282,000 and 29.7% for the similar period in 2007.

 

Item 3. Quantitative and Qualitative Disclosures about Market Risk

 

Market Risk

 

Interest rate sensitivity and the repricing characteristics of assets and liabilities are managed by the Asset and Liability Management Committee (ALCO). The principal objective of ALCO is to maximize net interest income within acceptable levels of risk, which are established by policy. Interest rate risk is monitored and managed by using financial modeling techniques to measure the impact of changes in interest rates.

 

Net interest income, which is the primary source of the Company’s earnings, is impacted by changes in interest rates and the relationship of different interest rates. To manage the impact of the rate changes, the balance sheet must be structured so that repricing opportunities exist for both assets and liabilities at approximately the same time intervals. The Company uses net interest simulation to assist in interest rate risk management. The process includes simulating various interest rate environments and

 

 

their impact on net interest income. As of June 30, 2008, the level of net interest income at risk in a 200 basis points change in interest rates was within the Company’s policy limits. The Company’s policy allows for a decline of no more than 8% of net interest income.

 

Imbalance in repricing opportunities at a given point in time reflect interest-sensitivity gaps measured as the difference between rate-sensitive assets and rate-sensitive liabilities. These are static gap measurements that do not take into account any future activity, and as such are principally used as early indications of potential interest rate exposures over specific intervals.

 

As of June 30, 2008, the Bank had a positive 90 day interest sensitivity gap of $11.4 million or 2.3% of total assets, increasing from $6.0 million, 1.3% of total assets as of December 31, 2007. The change was principally due to a decrease in time deposits maturing in 90 days. A positive gap means that rate-sensitive assets are greater than rate-sensitive liabilities at the time interval. This would indicate that in a rising rate environment, the yield on interest-earning assets would increase faster than the cost of interest-bearing liabilities in the 90 day time frame. The repricing intervals are managed by ALCO strategies, including adjusting the average life of the investment portfolio, pricing of deposit liabilities to attract longer or shorter term time deposits, loan pricing to encourage variable or fixed rate products and evaluation of loan sales of long-term fixed rate mortgages.

 

June 30, 2008

Rate Sensitivity Table

(dollars in thousands)

 

 

 

 

 

Item 4. Controls and Procedures

 

The Company’s management evaluated, with the participation of the Company’s Chief Executive Officer and Chief Financial Officer, the effectiveness of the Company’s disclosure controls and procedures, as of the end of the period covered by this report. Based on that evaluation, the Chief Executive Officer and the Chief Financial Officer concluded that the Company’s disclosure controls and procedures are effective to ensure that information required to be disclosed by the Company in the reports that it files or submits under the Securities Exchange Act of 1934 is recorded, processed, summarized and reported within the time periods specified in the Securities and Exchange Commission’s rules and forms.

 

There were no changes in the Company’s internal control over financial reporting that occurred during the Company’s last fiscal quarter that have materially affected, or are reasonably likely to materially affect, the Company’s internal control over financial reporting.

 

PART II. OTHER INFORMATION

 

Item 1. Legal Proceedings

 

Not applicable

 

Item 1A. Risk Factors

 

There have been no material changes in the risk factors affecting the Company that were identified in Item 1A of Part I of the Company’s Form 10-K for the year ended December 31, 2007.

 

Item 2. Unregistered Sales of Securities and Use of Proceeds

 

 

(1) Purchases related to the Company’s Employee Stock Ownership Plan (ESOP) related to purchase of shares from terminated participants.

 

 

 

(2) On March 19, 2008, the Registrant announced its intention to repurchase up to 5% of its outstanding common stock (approximately 137,000 shares) in the open market.

 

Item 3. Defaults Upon Senior Securities

 

Not applicable

 

Item 4. Submission of Matters to a Vote of Security Holders

 

The Annual Meeting of Shareholders of the Company was held on April 22, 2008. The following incumbent directors were nominated and duly elected to the Board of Directors for a three-year term expiring in 2011.

 

There were no abstentions or broker non-votes.

 

Ratify the appointment of Beard Miller Company LLP as independent accountant of the Company for the fiscal year ending December 31, 2008.

 

 

 

Item 5. Other Information

 

None

 

Item 6. Exhibits

 

 

 

 

 

 

 

 

Signatures

 

Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.